Mid-Year Warranty Report:

The good news continues into the first half of 2011, with massive warranty cost reductions extending their streak into a ninth straight year. With sales finally getting back to normal, product reliability has never been better, and repair costs have never been lower than they are now.

Despite all the headlines about U.S. manufacturing jobs moving overseas, about disappointing sales volumes and a loss of competitiveness, the warranty news is actually quite encouraging. Those who practice the profession of warranty management are getting really good at what they do, and the statistics are starting to show it.

The most exciting news is the continuing reduction in warranty costs, a combination of higher sales, lower failure rates, and less expensive repairs. Across multiple industries, U.S.-based manufacturers are now paying out a smaller percentage of their revenue for warranty work than ever before. And that is happening because products are being built better than ever before.

There's a product quality story here that's just screaming to be told. Major manufacturers continue to drive down their warranty costs as a percentage of product sales. How major? Here's a sampling of some of the biggest names, all of which have reduced their warranty costs by 5% or more in the past year: Cisco Systems Inc.; Cummins Inc.; Deere & Co.; Dell Inc.; Ford Motor Co.; General Motors Co.; Hewlett-Packard Co.; IBM Corp.; Ingersoll-Rand plc; and Whirlpool Corp.

Lowest Warranty Costs Ever

In Figure 1 below, we can see the average claims rate for all U.S.-based manufacturers falling to 1.36% in the second quarter of 2011, down significantly from both the first quarter and from the end of 2010. And except for the recession-driven spike in claims rates seen in 2008 and 2009, this is a trend that's been in play since we began collecting warranty data in 2003.

The average accrual rate is even lower, at 1.33%, and is also significantly lower than it's ever been before. And that's a trend that wasn't interrupted by the recession. In Figure 1 below, the green line shows how trend has been down year after year, with only a few upwards bounces. And just when it looked like the curve was flattening late in 2010, it went lower yet in 2011.

Figure 1 adds two additional quarters of data to a chart we last included in the April 1 newsletter. At that time, we noted that the average accrual rate for all manufacturers had never been higher than it was in 2003 and had never been lower than it was in 2010. Well, now it's lower. And that's a cause for celebration. Warranty managers, design engineers, and financial planners are doing a better job than ever before. Product reliability has never been higher, and warranty costs have never been lower.

FIN 45 Accounting Rules

We must caution our readers, however, to keep in mind that multiple manufacturers have chosen to release their warranty expense reports only once a year, at the end of each year. So we're inserting placeholder estimates for their first, second, and third quarter reports, until we can get a hold of the fourth quarter data.

However, the point is that our placeholding estimates may in fact be too low for 2011, and perhaps that's dragging down the average? We won't know for sure until March or April of next year, when all the annual reports arrive. But we doubt it will move the curve by much. And it definitely won't reverse the overall direction downward.

Change For the Better

Among the hundreds of companies that are filing quarterly warranty expense reports, however, there is a strong downward current. For instance, among the top 100 warranty providers of 2011 (measured by claims paid), 57 saw their claims rate fall, while 31 saw their claims rate rise, in the year between June 2010 and June 2011. Among all manufacturers, large and small, 65% saw their claims rate fall; 59% saw their accrual rates fall; and 45% saw both rates fall together in the past year.

The claims rate for the 11 annual filers are set to be unchanged from 2010. And then one member of the top 100 -- Bucyrus International Inc. -- was acquired by another top 100 member (Caterpillar) and therefore has now ceased reporting its warranty expenses separately. So after those dozen companies are taken out, our top 100 list has only 88 members whose claims and accrual rates could actually change. But most saw a change for the better.

When we grouped all manufacturers into one of 14 industry segments, as we have in past newsletters, we found that there were only slight changes. Compared to the pie chart included in the April 1, 2011 newsletter, the figure below shows only a slight enlargement of the automotive OEM and computer OEM slices. The auto OEMs have grown from 35% to 36% of the pie, while the computer OEMs have grown from 21% to 22%.

Figure 2
All U.S. Manufacturers
Claims Paid per Industry, First Half 2011
(as a % of $11.7 billion total)

All other industry segments are more or less the same as they were six months previously. So far in the first half of 2011, all U.S. manufacturers have paid out around $11.7 billion to satisfy warranty claims, about 1.5% more than they had at this same point in 2010. However, their product sales are up 13% in the first half, so the overall claims rate has fallen significantly.

Comparing Companies

In Figures 3 through 6, we're going to do something that indirectly compares the warranty costs of all manufacturers in all industries. We can't compare companies to each other, because each might include or exclude different cost components in their warranty expense calculations. For instance, one might include the cost of product recalls while another may not. There's no list of what to include or exclude in FIN 45, so each company is free to design their own checklist.

We do, however, believe that a company uses the same checklist from year to year, unless they announce a major change in their methodology, or a major change in the way they segment their revenue. So what we're going to do is compare each top 100 company to itself, from the middle of 2011 to the middle of 2010, and then rank all those changes in order, from the largest increase to the largest decrease.

In Figure 3, we've listed the top ten decreases in claims rates, taken from among the top 100 warranty providers. These are the companies that have done the most to help drive down the average claims rate seen in Figure 1 to new lows. They're the companies that have reduced the percentage of sales that goes towards paying for warranty claims, through either increased sales or decreased payments, or through a combination of both.

Harris Corp. is at the top of the chart because it was able to reduce its warranty claims payments from $29.2 million in the first half of 2010 to $11.6 million in the first half of 2011. However, we should note that the company also changed the way it segments its revenue, so that now the units that make the warranty-covered hardware are mixed in with non-warranted services and other revenue sources. So that also drives down the percentages by driving up the size of the denominator.

Nevertheless, Harris is one of four companies that have seen the greatest decreases in both their claims and accrual rates. The others are Ciena Corp.;
Microsoft Corp.; and Terex Corp.

Ciena actually paid out $2.4 million more in claims in 2011 than in the same period of 2010. But its product sales nearly doubled, so the claims rate fell from 2.9% to 1.9%. Terex cut its warranty payments by 25% and boosted its sales by 36%, and the result was a 45% reduction in its claims rate, from 2.5% to 1.4%.

End of the Xbox Crisis

Microsoft, meanwhile, is now almost finished recovering from its Xbox 360 game console warranty disaster. Back in late 2007, the company was spending more than $3 million a day repairing defective Xbox consoles. In 2010, it was still the 18th largest warranty provider in the U.S., with total claims of $188 million. Now, it's fallen to 32nd place, with warranty costs dipping below $750,000 per day during the months of April, May and June. And if the sharp falloff in claims continues, it may be out of the top 50 by year's end.

The ten companies listed in Figure 4, however, have little to celebrate. For one reason or another, they have seen their claims rates rise the most since the middle of 2010. FMC Technologies Inc., for instance, has seen its claims rate more than triple, from 0.2% in mid-2010 to 0.7% in the most recent quarter. That's because warranty claims doubled while warranted product sales rose only 22%.

FMC is one of three companies in Figure 4 that are also listed in Figure 6 -- the top ten accrual rate increases of 2011. The other two are Diebold Inc. and United Technologies Corp. Companies rarely release a cause or a detailed breakdown of the divisions or product lines that cause these increases. But FMC is heavily into the oil drilling equipment business. Diebold makes automated teller machines and electronic voting equipment. United Technologies makes everything from air conditioners to airplane engines. We'll leave it to their investors to ask why warranty costs are rising so fast.

Reducing Accrual Rates

Figure 5 is perhaps the best chart of all. While the claims rates are something that happens to a company, the accrual rates are something that a company makes happen. Each manufacturer decides an appropriate level for their accruals, based on their best guess of future warranty costs. So a massive cut in a company's accrual rate is a massive signal to the market that either the products are failing less often or are costing less to fix, or a little of both.

With claims, as we've seen, a falling claims rate can be the result of rising sales, rather than rising quality. But since the accrual rate should always remain proportional to sales, a reduction in the rate is usually a good sign.

So congratulations to the ten companies listed in Figure 5. As was mentioned, four of these ten also made the list in Figure 3. But five of the remaining six also saw their claims rates fall by less-than-top-ten amounts. The only one on this list that saw its claims rate rise was Oshkosh Corp., but we'll blame that on falling sales -- something that shouldn't alter the accrual rate.

As with claims, Microsoft was the big winner here. It set aside less than half as much in accruals, and its game console division saw sales rise by 8.2%. So its accrual rate fell by 65%. Harris, as we mentioned, changed the way it reports revenue. But it also cut accruals from $17 million to $9 million. And Ciena cut its accruals from $8.8 million to $5.6 million, despite a 94% sales increase. Absent an increase in quality, accruals should have risen to $17 million.

Some companies cut their accruals even though claims and sales remained relatively flat. For instance, Whirlpool saw sales rise 4%, while claims fell 1%. But it still managed to cut accruals by 30%, from $246 million to $172 million. And that combination produced a 33% decrease in its accrual rate, from 3.6% to 2.5%. That's a strong indicator of increasing product reliability, which comes just in time for the company's 100th anniversary.

Of our top 100 warranty providers, or at least the 88 for which we have new data, 54 cut their accrual rates in the past year. Besides the ten listed in Figure 5, another eight companies cut their accrual rates by 20% or more. They are: Hovnanian Enterprises Inc.; Ingersoll-Rand plc; Johnson Controls Inc.; NCR Corp.; NVR Inc.; Rockwell Automation Inc.; Thor Industries Inc.; and TRW Automotive Holdings Corp. Congratulations to all of them.

And Now the Bad News

Our condolences go out to those listed in Figure 6. As we mentioned, accrual rates are something a company chooses to change. And no company would choose to raise their rates by the most among their peers, unless there was a major problem. And the problem can't be passed off to falling sales. Seven of these ten companies saw sales rise.

FMC is again at the top of this chart. While sales rose 22%, accruals rose from $12 million to $17 million. And that caused the accrual rate to more than double, from 0.5% to 1.3%. But EMC and Kodak also had to raise their accrual rates dramatically. And now EMC and FMC are listed in the same chart, probably for the first time ever. Luckily, General Motors Co. didn't make it onto any of these top ten lists, or we could have had a GMC on there as well.

Predicting the Future

NetApp, we should note, actually saw its claims rate fall, thanks to rapidly rising sales. But accruals rose faster than sales, so the percentage rate grew by 41%. EMC and Harley-Davidson also raised their accrual rates despite falling claims. So they must be anticipating some cost increases in the future that haven't yet shown up in the current statistics.

Besides the ten companies listed in Figure 6, an additional seven top warranty providers raised their accrual rates by 20% or more in the past year. They are: Apple Inc.; Applied Materials Inc.; Caterpillar Inc.; Mohawk Industries Inc.; Nvidia Corp.; Standard Motor Products; and Textron Inc. Only one of those seven made any of the other lists: Standard Motor Products is part of Figure 4. Five of the six others, however, raised their accrual rates despite falling claims rates. So again, they must see something coming that hasn't yet arrived.

Among the 88 largest companies for which we have data, only three out of ten saw their claims and accrual rates change in opposite directions. Only 15 saw their claims rates fall while raising their accrual rates. And only 12 saw their claims rates rise while cutting their accrual rates.

Most were in agreement: 19 saw both rates rise, and 42 saw both rates fall. Among the smaller and medium-sized warranty providers, the same ratio holds: roughly two-out-of-three see rates rise or fall together, while only one-in-three sees them move in opposite directions. So again, this shows a sharpening of skills when it comes to warranty management and finance.